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From The Radio In The News My Two Cents PSA

Know When to Hold Them

I am the absolute worst gambler. Several years ago, I headed out to Las Vegas to celebrate a friend’s 30th birthday, spent a lot of time in the casinos, and very little time gambling. My friend discovered that if she was sitting in front of a slot machine, occasionally pushing the button, she got drinks for free. Sitting next to her, I benefitted from this perk. Thus, we spent a lot of the long weekend chatting and sipping on drinks, while hanging out near a slot machine. It was a lot more fun than it generally has been when I lose my money in a casino. I am sure there are may strategies and techniques that people employ when gambling, but I don’t even know the theories, so I tend to essentially throw my money at a machine or croupier and hope for the best.

When it comes to some financial terms that are being bandied about in discussions about GameStop, I can at least try to explain what the terms mean. I find that what is going on in the stock market right now involves many short words that may be more complicated than they sound. Hopefully, clarifying them will help us all get a better idea of what is going on. I am going to speak about shares (because that is what is at play with GameStop) but these financial terms apply to all kinds of securities. Securities are financial instruments that are tradable and fungible, or mutually interchangeable. The fungible characteristic is what makes securities so easily tradable. Securities being fungible means that they are for all practical purposes, considered to be identical and can be exchanged for one another. You can exchange one $20 bill for two $10 bills. In contrast, though they are both seats one does not consider a front row seat to be the same as a back row seat, especially if everyone in front of you is way taller, so these seats are non-fungible.

I shall start out by talking about buying on margin. In the stock market, when you buy on margin, it means that you are buying securities using only a percentage of your own money. For example, say you want to buy a share for $100 but only have $10 to your name. You approach your local broker and that broker agrees to lend you $90 to get you to the $100 to buy that share. Because just about nothing in life is free, the broker charges you 10% interest on the $90. In a year, you decide to sell that share. When you do that, you will need to repay the broker $90 plus $9 in interest. If you skipped over those sentences because you saw numbers and didn’t want to to math, buying on margin means you only need to use a fraction of the money needed to buy shares and you can borrow the rest, paying interest. If you are able to sell the shares for more than what you paid to buy it, that’s great. You can use your profit to pay back your loan (plus interest) and happily take the rest home with you to do with as you please. However, if the price of the shares goes down, you will lose your money and may have to find money elsewhere to repay your loan. In the United States, the Financial Industry Regulatory Authority (FINRA) generally requires that a customer use 50% of their own money for their first time or initial purchase of securities. People who want to short sell securities, also need margin accounts.

For all the people who are optimistic about share prices and financial markets, there are those who look at securities and believe that the value of the securities will go down. Some may call these people pessimists, and these people may call themselves realists. Po-tay-to or Po-tah-to, these folks seek to benefit from their price downturn point of view by doing what is called short selling (or shorting) the security, and this is how shorting works. Pessireal (as we shall call them) goes to their broker and says, “I would like to borrow one $100 share of Tulip stock. Everyone is all about Tulip these days, but I just don’t see that ending well.” The broker will then sell a $100 share of Tulip stock, and give the $100 to Pessireal, less any transaction fees (again, nothing for free). Pessireal will then sit back, wait, and watch the market. If Pessireal’s gut is correct about Tulip and that the value of the share goes down to $50, Pessireal will take $50 of the $100 and buy a share of Tulip stock which they will give to the broker to, as they say, close the short position. So, Pessireal is giving back the borrowed share and has made $50 (less fees) while they’re at it.

Suppose, however, that Pessireal is wrong about Tulip, it becomes the best thing since sliced bread, and nothing can keep its price down. Pessireal may realize the error of their ways and decide to cut their losses when the share price is $200. In addition to the $100 they got from their borrowed share, Pessireal will have to spend an additional $100 of their own money to buy the share they need to return to the broker. Although this is rare, sometimes it is the broker who may decide that they want their share back. It could be because the broker has been watching Tulip’s share price going up and when it gets to $300 a share, they start to fear that Pessireal won’t be able to pay them back. So they call Pessireal up and, despite’s Pessireal’s attempts to assure them that Tulip’s demise is on the horizon, they demand their share be returned. This means, whether they like it or not, Pessireal will have to find an additional $200 to bring the $100 from the borrowed share up to the $300 needed in order to buy a share of Tulip and return it to the broker.

With the regular trading of securities, the worst that can happen is that the value of your investment can go down to zero. That hurts but at least you know that the most you can lose is what you put in. The best that can happen is pretty much infinite. Your gain is whatever the price of the security goes up to be, over what you put in. Short selling is the opposite. You can calculate the most you can earn on a security – the lower the price goes, the more you make, up until the security is worthless. On the very scary flip side, the most you can lose is pretty much as high as the share price soars, which could be, as GameStop short sellers are finding out, can be pretty darn high. Brook Gladstone, the host of On The Media, shared that she spent almost $1,000 on 42 shares of GameStop stock in 1999 and by April 2020, that investment was worth $3.50 a share – $147. She sold her shares when they were at $100 a share. Most of last year, GameStop’s stock was valued at $250 million. The stock has exploded to a point where GameStop’s stock value is around $20 billion! If you are a short seller, that hurts.

The last thing I will mention here is the short squeeze. Say, Pessireal was not alone in thinking that Tulip’s share price was going to crash, and that many had decided to short Tulip but, instead, that price was soaring. Some short sellers may take a look at the soaring price and at their sources of funds and decide that they were ready to cut their losses. If there were enough of these short sellers looking to buy Tulip shares so that they could return them to their brokers, and close the short position, this higher demand could push the share price even higher. Right now, with GameStop (and other stocks) there are a lot more people looking to buy shares than are looking to sell. The trusty supply and demand chart comes in to show how the increased demand will increase the price. The short sellers, looking to cut their losses and repay their borrowed stock, are, in turn, squeezing that price up too.

I can’t say when and how this will end; I am no good at the Vegas game. Heck, I can’t even let what happened in Vegas stay there. I do, however, hope that as you read or listen to stories that are throwing out financial terms, you will nod along and think – I get it.

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In The News Inspiration

More Equal Than Others

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Every time he is channel surfing and comes across The Godfather, my husband, James, watches it. It doesn’t matter whether the film is one minute or one hour in, he stops and watches the rest of the movie. He never tires of it. He is happy to watch The Godfather every day of the week, if that is how often it pops up on the television. In high school, I had a similar relationship with Animal Farm (and some other books). It is a good thing that I didn’t mind reading Animal Farm, because it was a book we studied, at great length, in school. It has been many years since I read the book, but the commandments stick with me. For those that have not read Animal Farm, in a nutshell, animals on a farm rise up against the humans and come up with seven commandments. The commandments include declarations like “No animal shall drink alcohol” and “No animal shall kill any other animal”. However, as time goes by, some animals are sucked in by the intoxicating nature of power and the commandments are amended – “No animal shall drink… to excess” and “No animal shall kind any other animal… without cause”. This week, when Jim Ulvog wrote to me about UBS in the news, I was reminded of the commandment that was, initially, “All animals are equal” but morphed into “All animals are equal… but some are more equal than others”.

Last year, when writing about high frequency trading, I mentioned dark pools. Watching the news, the stock market that gets the most coverage is the New York Stock Exchange (NYSE). However, there are 16 national securities exchanges and then there are a further 45 so-called dark pools. Dark pools are not easily accessible to the public and are run by private brokerages. UBS ran one such brokerage and the SEC charged this brokerage with telling its customers that they were all equal while behaving as though some customers were more equal than others. In doing this, they not only violated their customers’ trust, they also, allegedly, violated securities law.

Dark pools are so-called because they give anonymity to the traders who use them. Like an extreme version of poker, in dark pools, the identities of the traders and the size of their orders are kept secret until the orders are filled. In this way, dark pools give traders the freedom to trade without other parties being privy to what they are doing. However (according to the SEC’s charges), with UBS, it turns out that UBS was operating its dark pool at an additionally shady level and giving some of its clients flashlights. For example, to its market makers and high-frequency traders, it gave the option, called PrimaryPegPlus (PPP), of being able to bid in fractions of a cent, despite this practice being illegal. So these PPP customers were able to jump ahead of customers bidding in, legal, whole penny prices. Furthermore, UBS did not disclose this and other practices to all its customers. So the uninformed customers were trading in this dark pool, thinking that they were equal to the other members of the dark pool, while, in reality this was not the case. It is as though UBS held a road race that a bunch of people entered but then UBS picked out a few cool kids and, secretly, gave them rocket-propelled shoes.

Trading in the various securities markets is complicated enough as it is, with some players being more experienced and sophisticated than others. We have high-frequency traders who use complex tools, large volume and nano-second speeds, tools that the ordinary man on the street generally does not have access to. To add to all of this complexity, if you have the markets advertising themselves as one thing, but selling something completely different, something that gives clandestine, unfair advantage to a group of clients over another, that just doesn’t sound right. It didn’t sound right to the SEC either – they fined UBS $14.5 million (even though UBS neither admitted nor denied guilt when paying the fine). Maybe that’s because the Animal Farm commandments are, right or wrong, just the way things are?

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From The Radio In The News NPR What's Going On?

Hold On!

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A few weeks ago, I took a walk in Prospect Park with a friend. We had not caught up in a while and I had a lot to talk about. I am a judge for the Excellence in Financial Journalism Awards, presented by the New York State Society of CPAs, and I had just finished reading the many entries submitted by very talented journalists. Several submissions were on the subject of high-frequency trading and I was fascinated by the reports that I had read and watched. As I launched into my story, she interrupted me and asked, “What is high-frequency trading?”

I was less surprised by her question than I would have been three or four days earlier. This is because I had been asked that question every time I had started talking to people about high-frequency trading. Initially had been surprised that so few people knew about high-frequency trading but then I realized that I couldn’t assume that, just because I own the t-shirt, everyone else is a huge fan of Planet Money or, indeed just because I have the sweatshirt, the rest of the world is hooked on Radiolab. Both shows have covered the subject of high-frequency trading. Planet Money, in particular, has spoken extensively about high-speed trading.

That night, no joke, I tuned in to watch 60 Minutes and Steve Kroft was talking with Michael Lewis about his new book, Flash Boys, which talks about high-frequency trading and how it has negatively affected how stock markets work. Flash Boys is a popular book right now but, I wonder, though we are throwing around the term HFT (the now popular acronym for high-frequency trading) and discussing how markets are affected by HFT, how many of us really know what HFT is?

Watching television or the movies, the portrayal of the stock market has not changed much in decades. Bells ring to announce the opening and closing of the market and, in between, we see massive rooms of men (and it is just about always men) avidly watching screens of numbers, yelling madly and waving pieces of paper. Would you be shocked to discover that the stock markets are not “as seen on TV”? The markets have not operated in that way for a while now; things are far more complicated. Currently, there are 16 regulated national securities exchanges in the United States (and another 45 or so dark pools, which are not open to the public) and most of these exchanges are nowhere near Wall Street. Most trades are executed electronically and many of these trades are executed by computers using powerful algorithms. Initially, when electronic exchanges were first launched, there was a rule that, although the exchanges were computerized, orders had to be entered through the keyboard. The challenge to those using the electronic exchange, was how to be able to trade quickly and one such trader, Thomas Peterffy, built a typing robot to satisfy this requirement while increasing the speed of trading. The speed he achieved then is a joke compared to what high-speed trading looks like today.

Now there are no such rules and now the algorithms used by high-frequency traders have computers making multiple trades in fractions of a second. In addition to this, high-frequency traders can make trades and cancel them without paying fees for doing so. These traders are known to flood a market with orders, to get a feel of what is going on in that market, and then cancel the orders almost immediately. In fact, almost 97% of trades made in the US stock market are canceled and the bulk of these cancellations were from high-frequency traders. This activity tends to manipulate stock prices and, as a result, high-frequency traders can make pennies on trades. Because they can trade at incredibly high speeds and volumes, these pennies can add up pretty quickly to healthy returns. The returns are tempting enough that HFT entities are willing to pay to get information a mere two seconds before other people and are also willing to pay to get a few feet closer to the trading floor than their competition.

Now, how do two seconds and a few feet make a difference? This is because of the speed at which information can be processed and sent between traders and their markets. Any innovation that gets traders to the market before their competition so they can buy at a lower price and sell at a higher one is one worth spending on. This is the essence of high-frequency trading and traders able to execute millions of trades per second, can make many fractions of a cent add up to many dollars over a short period of time. The volume of trading has exploded in the last decade and the Nanex graphic of this activity is a very powerful visual.

Things can also go horribly wrong in markets with high-frequency trading. On May 6, 2010, at 16:42:44 (yes, down to the second) the stock market plunged 600 points in five minutes and this drop was stopped only when the market paused trading for 5 seconds and then started up again. The market regained the 600 points almost as quickly and as mysteriously as it had lost them. There is no consensus on what caused the Flash Crash of 2010, though most point to high-frequency trading as at least one of the factors responsible. That people cannot agree one what the causes of the crash were and that it took almost half a year for the SEC to come out with a report on what happened, shows just how complicated and difficult to understand trading and, in particular high-frequency trading are. I mean, once we start talking high math and algorithms, most of the world’s population is left cross-eyed and dizzy (and that means, me too).

There is no shortage of opinions to be found on high-frequency trading. Some use everyday English and exciting anecdotes to explain themselves while others employ fancy acronyms, mathematical phrases and financial-speak to put forward their thoughts. Whatever opinions and explanations you decide to explore, the first thing to do is to understand the basics of what they are talking about. How, really, can you have an opinion if you don’t even know what people are talking about? This is a very fast market. Nanosecond quick, so you better hold on!